Introduction to Islamic Finance (Part I): Context and Concepts
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Globally, Islamic finance is one of the fastest growing areas of finance, however measured. So says the popular press. Practitioners concur. The foundation for such assertions, like much that is “known” about Islamic finance, is anecdotally based. Hard numbers are elusive and probably nonexistent.
The dramatic rate of growth of modern Islamic finance, since its birth in the mid‐1990s, is clear. Lawyers, accountants, bankers, and investment firms now proclaim long experience with Islamic finance, enhancing the pool of anecdotal evidence. The publicity, the perception of growth, the simultaneous influx of oil wealth into traditionally Muslim countries, the formation of financial centers, and the rapid regional expansions all work to further expand both interest in and assertions of experience.
Conventional Western lease financings (such as leveraged or synthetic leases) and securitizations are good examples of structured financing for the purposes of our discussion. Each has its counterpart in the Islamic finance realm. In fact, most types of Islamic finance transactions will be quite familiar to Western finance specialists. (There is nothing new under the sun, but the reader should bear in mind that this essay, of necessity, focuses on differences between Western and Islamic finance. In reality, the similarities far exceed the differences.) Most derivatives transactions, while a type of structured finance, are without direct counterpart in the realm of Islamic finance because these transactions do not have a tangible asset as a primary transactional focus. However, in March 2010 the International Swaps and Derivatives Association (ISDA) introduced the Islamic finance equivalent of the 2002 Master Agreement Protocol, which is called the 2010 Tahawwut Master Agreement, which creates a Shari`ah-compliant derivatives counterpart mechanism. This is illustrative of the direction of change in this infant industry.
Islamic finance at all times focuses on, and is governed by, a set of ethical parameters that are in many ways essentially identical to those underscoring other ethical or socially responsible investing. In other ways, the principles of Islamic finance reflect and embody the unique elements of the religion of Islam. These principles are little understood, despite the confident assertions of the newly‐initiated. They are difficult to study and understand, if only because of the infancy of the industry and the absence of written compilations. Given the absence of dependable texts, these principles must be learned “at the knee” through study with the limited number of scholars of Islamic Shari`ah.
Few comprehend and appreciate that these principles, insofar as they constitute a body of substantive and procedural law, are 1,400 years old, and more comprehensive than any secular legal system that they have encountered as practitioners or historians. Rarer still is the realization that the practice of Islamic finance is not limited to the Muslim countries of the Middle East, Southeast Asia, and North Africa but is practiced daily in North America and Europe, among other “Western” jurisdictions.
This essay provides a summary introduction to some of the context and essential concepts, elements, principles and structures of modern Islamic finance. It begins by defining the Shari`ah, as applicable in commerce and finance, which necessarily includes consideration of the nature and function of Shari`ah boards and the evolution of certain principles and concepts that are central to the practice of Islamic finance in contemporary times. The essay continues with a survey of some of the contractual and structural paradigms at the heart of modern Islamic finance transactions.
Each of the topics discussed in this essay, and others, will be discussed in greater detail in the half‐day session on Islamic Finance being offered by the author and the New York State Society of Security Analysts on November 23, 2010, in New York City.
Islamic finance is concerned with the conduct of commercial and financial activities in accordance with Shari`ah. The word “shari`ah,” in its early usages, referred to the path by which camels were taken to water, to the source and essential sustenance element of life. In later and current times, it refers to “the way” or “the path” by which a Muslim is to conduct his or her life, in every aspect of life. It is comprised of and embodies religion, ethics, morality, spirituality, humanitarianism and takes the form of behavioral, civic and political admonitions, as well as legal requirements (both ritualistic and transactional) and “law” as conventionally conceived. It is in part divine revelation, in part human example, and in part human ratiocination. Joseph Schacht viewed it as “the epitome of the Islamic spirit … the kernel of Islam itself.” Al‐Ghazali referred to the Shari`ah as the “indispensable daily bread of life.”
As a body of divine law that has developed over 1,400 years, it is conceptually mature and, by definition and essential nature, comprehensive. Like the common law, elucidation of principles in application is done on a case‐by‐case in reference to specific factual situations. As a result of the centuries‐long dominance of interest‐based finance, however, it is somewhat undeveloped in application to modern commercial and financial transactions.
The Shari`ah, being comprehensively applicable to all aspects of human endeavor and existence is, by definition, applicable to all, and every aspect of, commercial and financial matters. There is no secular legal doctrine without a Shari`ah counterpart. Concepts pertaining to sales and partnerships are particularly well‐developed, which is not surprising given the primacy of trading activities and ventures in the early years of Islam. Like any other mature body of law, application of the principles and precepts is detailed, complex, and subject to interpretive variations. These variations are one of the complexities in modern Islamic finance; one of the major trends since the mid‐1990s is the effort to harmonize interpretations among madhahib (schools of Islamic jurisprudence).
The Shari`ah is the perfect, immutable, divine law as revealed in the text of the Qur’an, and the sunna. Fiqh (“understanding,” from faqaha, “to understand”) is the sum of human comprehension of that divine law and is given effect in the practical rules of the Shari`ah as determined by trained Shari`ah scholars.
The primary methodology employed in this determinative effort is ijtihad (literally, “effort”), or legal reasoning, using, as the primary sources, the “roots of the law” (usul al‐Fiqh). The primary sources, in Islamic Sunni orthodoxy, are (a) the Qur’an (the divine word of Allah), (b) the sunna (the practices and examples, the dicta and decisions, of the Prophet Mohammed), (c) ijma` (consensus, most particularly, in current practice, among that of the community of scholars), and (d) qiyas (analogocial deductions and reasoning). Hadith are the textual records of the Prophet’s sunna, as determined by skilled juristic scholars.
Conventional Western finance is firmly based on the concept of interest, the accretive earnings on money with the passage of time, or amounts in excess of principal (i.e., riba), and related risk‐reward structures, particularly payment preferences in financing contracts and related collateral security structures. In conventional Western finance, money is a medium of exchange, a measured store of value, and a commodity in and of itself: an asset that can itself earn money.
The Shari`ah and Islamic finance are premised quite differently: the risk‐reward conception is fundamentally different. These differences are of more than academic interest; they must be addressed in all Islamic finance transactions. Risk sharing is the requisite and justification for profit and loss sharing. Sales and partnership conceptions are risk‐reward paradigms. Rewards without commensurate risk, and preferential rewards, are impermissible. riba is impermissible. The interest‐based debtor‐ creditor paradigm is rejected, although debtor‐creditor constructs are acceptable (if derived from Shari`ah‐compliant arrangements). For the most part, predetermined fixed returns and guarantees or assurances of return of or on capital are impermissible. The use of money as a commodity is unacceptable. Money is not an asset that can itself earn money; it is a measured store of value and a medium of exchange. Financial transactions must involve a tangible asset (with limited exceptions). Application of these principles precludes the sale and purchase (at least at a premium or discount) and tradability of pure financial instruments that do not represent interests in tangible assets, such as mortgage loans (which also include riba elements), debts (including receivables, which frequently include riba elements) and derivatives.
The methodology and historical tradition of Islamic jurisprudence are also without counterpart in conventional finance. They include a system of historically accepted “nominate contracts,” which are rather rigidly defined contracts or structures (leases, partnerships, sales, etc.). Since the mid‐1990s, it has no longer been imperative to adhere to the precise historical form of the relevant nominate contract as a self‐contained transactional structure; nominate contracts may now be combined as “building blocks” in composite structures. But the historical forms continue to work as significant constraints on the nature and structure of Shari`ah‐compliant structures, contracts, and instruments.
Given its breadth and complexity, as with any mature body of law, comprehension of the nuance of the Shari`ah is frequently difficult for the lay person. Additionally, compliance is a matter of individual conscience. As such, different madhahib have arisen over the course of history. The four main Sunni schools, and those primarily impacting modern Islamic finance, are the Hanafi, Hanbali, Maliki, and Shafi’i. Each madhahib (meaning “path” or “road to go”) is a body of juristic opinions and a related methodology of how to use text, tradition, and reason to understand pure Shari`ah. Historically, the different madhahib frequently interpreted and applied the Shari`ah differently to different factual or structural situations, and there have been variations even within individual schools, trends that are exacerbated by the case‐by‐case method of elucidation.
Shari`ah scholars play a prominent role in the interpretation and application of the Shari`ah, particularly in finance. They advise on the application of general Shari`ah principles and precepts as specific “legal” injunctions. Islamic banks and financial institutions; some higher net worth families and individuals; and sponsors and managers of Shari`ah‐compliant funds, investment products, and assets retain one or more Shari`ah scholars, who comprise a Shari`ah board, to assist in making the relevant determinations. These boards oversee the complete range of investment and asset management practices, as well as the principles, methodology, and operational activities, of the entity or individual that has retained that particular board. This oversight extends to every element of these activities, including transactional structures and documentation. Each board will certify, pursuant to fatawa (legal opinions; fatwa is the singular), the Shari`ah compliance of a given fund, structure, or instrument, usually on a confidential basis on behalf of the retaining party or entity. As a result, Islamic finance tends to develop without formal coordination across markets or madhahib.
Efforts at harmonization are individual (informal coordination and discussion among scholars) and institutional. Institutionally, harmonization efforts are exemplified by the existence and prestige of Shari`ah boards of the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), the Fiqh Academy of the Organization of the Islamic Conference (OIC), the Islamic Jurisprudence Institute of the Islamic League, the Islamic Development Bank, Bank Negara Malaysia, and the Suruhanjaya Sekuriti, Securities Commission of Malaysia, among others. Most determinations of these boards are advisory, although the determinations of the boards of AAOIFI, Bank Negara Malaysia, and Suruhanjaya Sekuriti are compulsory in certain circumstances.
The precise role of a Shari`ah board varies as a function of the unique relationship between the individual Shari`ah board and its retaining entity. Generally, a board will perform various roles, typically including (a) participation in product development and structuring; (b) review and approval of financial instruments and products; (c) review and approval of the fund or entity structure and its objectives, criteria and guidelines; (d) review and approval of disclosure and offering documents; (e) review, approval, and oversight of investment and business operational structures and methodology; (f) on‐going review, oversight and approval of transactional or operational variances or applications to unique or changing circumstances; and (g) annual audits of the operations of the fund or entity and issuance of an annual certification of Shari`ah compliance.
SOME HISTORICAL HIGHLIGHTS
For five or six centuries essentially all finance was interest‐based finance, reflecting global power dominances. Application of the Shari`ah was generally limited to familial relationship and inheritance matters. Devolution of the Muslim states after World War II presaged change. Essential to the existence of an Islamic state is an Islamic economy. Academic discussions of the 1950s and 1960s begat concrete actions in the 1970s: the formation of Islamic banks.
From the 1990s to the present, there were profound developments in the field of Islamic finance, virtually all of which are still ongoing. Five are of particular import:
(a) some Shari`ah scholars undertook to move toward consensus (ijma`), thereby reducing differences among madhahib (oddly, the oft‐decried shortage of Shari`ah scholars ensured that some key individuals in the consensus movement sat on multiple boards, thus moving the entire industry toward greater harmony, uniformity, and consensus);
(b) there was a transformative move away from the historical rigidity in the use of static nominate contracts toward their use in creative new “building block” combinations;
(c) bifurcated and other sophisticated transactional structures were developed that allowed expansive growth of the investment side of the Islamic finance industry and the participation of conventional financial institutions;
(d) in connection with the efforts of Dow Jones Islamic Indexes (DJIMI) to open the equity side of the capital markets to Shari`ah‐compliant investment, a seminal fatwa was issued that institutionalized the concepts of “permissible variance” and the correlative concepts of “purification”;
(e) sukuk were developed to allow access to the “debt” side of the Islamic capital markets.
The last two developments are worthy of further explication, given the misunderstandings about these developments.
Early real estate, private equity, construction, and project finance transactions were financed privately by commercial banks, at first as one‐off transactions and later as constituent fund investments. The capital markets were inaccessible due to lack of familiarity with Shari`ah‐compliant financing techniques in Western capital markets and the total absence of Islamic capital markets.
Prior to 1998, Shari`ah‐compliant investors could not even invest in exchange‐listed equity securities. (Every company paid or received interest; many engaged and engage in impermissible activities involving alcohol, pork, interest‐based finance, pornography, non‐mutual insurance, or other forbidden activities). In 1998, after five years of debate, a monumental fatwa was issued to DJIMI. It established a series of tests that are used to determine whether an investment can be made in an equity security of a company that is not totally Shari`ah‐compliant. These tests acknowledged, and sanctioned, on a conditional basis, a degree of variance from (or impurity relative to) the strict application of Shari`ah principles and precepts. Intertwined correlatives were the various “cleansing” or “purification” mechanisms to address the impure consequences of that variance. Thus, for example, if some interest income were obtained, it could be donated to charity to cleanse or purify the transaction. This fatwa opened the equity capital markets to Shari`ah‐compliant investors.
Generally stated, the DJIMI fatwa established two sets of tests. The first has two branches, involving the following questions: (i) is the subject security itself impermissible (because it constitutes a fixed income instrument such as preferred stock)?; and (ii) are the “core” business activities of the subject entity impermissible? Thereafter, the focus turns to whether the entity has an impermissible degree of riba as determined pursuant to a series of financial tests.
The principles addressed in the DJIMI fatwa have evolved considerably since first being set forth and have been carried into many other areas (such as private equity and real estate investing and project finance). And the financial tests have themselves evolved. The original tests were based on balance sheet information (which was the available information from 1993 to 1998): for example, total debt to market capitalization. Some more recent tests focus on operating statement information that is now available and thus use a gross revenue denominator and an actual interest income and expense numerator.
In 2003, the AAOIFI Shari`ah Board enunciated standards for the use of sukuk to access the capital markets: Shari’ah Standard No. (17), Investment Sukuk. Sukuk are commonly, if inaccurately, referred to as “Islamic bonds” and, more accurately, as “Islamic asset or whole‐business securitizations.” With only one exception, sukuk issuances have been bond (rather than securitization) structures, and the overwhelming percentage of issuances involve sovereign credits (although corporate issuances are increasing).
Since the inception of sukuk to November 7, 2009, there were US$955.22 million of issuances, total. Two countries predominate in issuances: Malaysia, with 44.8% of total issuances and 44.9% of total volume and Bahrain, with 25.2% of total issuances, but less than 7.00% of total volume. The United Arab Emirates was second in volume, with 30.7%. Mayalsia and the United Arab Emirates together accounted for 73.53% of volume. Saudi Arabia was third by volume, with 9.4%, (Since the inception of the financial crisis in 2007, Saudi Arabia’s volume has increased markedly.)
Financial services issuances comprised more than 25% by volume and 11% of total issuances, with a high average issuance size of US$314.68 million. Over one‐half of the total volume, and 40% of the total number, were in four industrial segments: financial services, real estate, transport, and power and utilities. This was reflective of infrastructure and real estate development patterns in the Middle East and Malaysia. Infrastructure issuances were, approximately, 60–68% by volume. Approximately 35% of issuances were identified as purely “sovereign,” although they amount to only 8.3% of total volume and have a relatively small issuance average (US$37.26 million).
Much is not yet determinable, given available data. First, the actual degree of government ownership of issuing entities, and sovereign support, is unknown: unreflected and hidden governmental ownership is likely significant. Second, the degree of overlap among the different industrial categories is not apparent or discernable. For example, it is likely that a significant number of issuances in the real estate, transport, and power and utilities categories (and others) are also “construction” issuances. Thus it is difficult to determine the purposes of most issuances.
As expected, sukuk al‐ijara (lease sukuk) comprise the largest portions of all issuances: 37.8% and 33.7% by number and volume, respectively. Second, in terms of volume, is the sukuk al‐musharaka (a partnership structure expressly addressed in the AAOIFI 2008 “clarification” noted in Part II of this essay) at 31.2% (and 13.1% of total volume). Use of the sukuk al‐murabaha (cost‐plus sale) is also frequent: 18.8% of issuances (9.2% of volume). Its small average issuance amount suggests frequent use for short‐term financings, such as working capital or commercial paper equivalents. (Bahraini Central Bank issuances a large part of this figure.) Together, sukuk al‐ijara and sukuk al‐musharaka comprise 40.3% of total volume and 31.9% of the total number of issuances.
Tenor is a critical issue in effective use of sukuk for the development of Islamic capital markets and a primary concern of practitioners. Only 3.69% of issuances have a tenor of 20 years or more, although these represent 19.8% of volume. Defining long‐term as ten years or longer, the figures are 16.44% of number and 38.1%% of volume. This bodes poorly, in the near term, for the financing of pressing infrastructure development needs. The musharaka‐mudaraba‐murabaha triad predominates in the long‐term category (63.64% in 20‐plus years; 52.04% in ten‐plus years). Ijara structures are a distant second (13.64% in 20‐plus years; 31.63% in 10‐plus years).
Sukuk structures, since 2003, have become increasingly indistinguishable from conventional bond structures, much to the consternation of the AAOIFI Shari`ah Board. In March 2008, the AAOIFI Shari`ah Board issued “resolutions” that “advise” the industry with respect to sukuk. The March clarification was an attempt, after numerous warnings, to curb the violative practices of a few conventional banks that had aggressively pursued involvement in sukuk issuances (albeit in a commendable effort to bring sukuk into the broader capital markets) and of the prominent capital markets law firms that advised those banks on Shari`ah matters.
To date, one sukuk issuance, the East Cameron Gulf of Mexico oil and gas royalties sukuk, has become the subject of a bankruptcy proceeding (in Louisiana). The nature of the sukuk was not at issue in the proceeding (although recharacterization motions were made), and the proceeding did not involve a determination of whether a Shari`ah‐compliant instrument can be enforced in the United States. Like most transactions in “purely secular jurisdictions,” the Shari`ah is not included in the governing law clause or elsewhere in the documentation: for U.S. law purposes, it is irrelevant. Shari`ah compliance was, and is, the sole province of the Shari`ah scholars. The sukuk was restructured and the sukuk holders took equity positions in the transaction.
The demand for Shari`ah‐compliant financing is increasing and will continue to increase. Capital is flowing into the oil and gas producing OIC countries, especially in the Middle East and Malaysia. Those countries, and others, are upgrading existing infrastructure, expanding infrastructure conceptions, and attempting to broadly diversify away from oil and gas. Capital from these jurisdictions will seek investments throughout the world, including in purely secular jurisdictions. In both cases, the demand for the use of Shari`ah‐compliant techniques, and for knowledgeable practitioners, will increase correspondingly. Fundamentally different conceptions of risk participation and related economic reward will have to be cooperatively resolved and accommodated in a manner that satisfies the competing economic, institutional, religious, political, legal, regulatory, and accounting constraints to which each of the participants is subject. To remain competitive, Western financial institutions, as well as Islamic financial institutions, will need to be fully conversant with these types of financing structures.
This essay has introduced a few of the fundamental concepts that must be mastered in order to achieve the requisite degree of cooperation (the fundamental structures are discussed in Part II of this essay). The hope is that these transactions will be viewed as a creative opportunity, the realization of which will enhance awareness and knowledge of both economic systems (interest‐based and Islamic) and of the fundamental cultural, moral, ethical, religious, and legal principles that guide the existences of people.
–Michael J. T. McMillen is a member of the New York bar; founding chair and senior advisor for the American Bar Association's Islamic Finance Committee; and an adjunct professor of Islamic Finance at the University of Pennsylvania Law School and Wharton School of Business. An earlier version of this essay appeared as "Contemporary Islamic Finance: An Introduction to Essential Concepts," 38 Law News 1 (American Bar Association, Section of International Law; Fall 2009), with a continuation online (available only to members of the American Bar Association, Section of International Law).
© 2009 and 2010, Michael J.T. McMillen; copyright and all intellectual property rights retained by Michael J.T. McMillen.